Central banks apply a costly Band-Aid

Harvey Enchin
The Vancouver Sun
Friday, March 14, 2008

World markets, including Japan's, rebounded Tuesday after an infusion of money from major central banks.

If there were any doubt that the world is in the throes of a financial crisis, moves by central banks in Europe, Canada and the United States this week confirmed our worst fears.
While their methods seem arcane -- establishing a "term securities lending facility," for instance -- their goal is painfully obvious: To avert a run on the banks and the failure of major financial institutions.

Such a calamitous outcome seems unthinkable sitting comfortably in Canada where the economy west of Thunder Bay still sizzles and the housing market crash south of the border has yet to depress local real estate prices.

But the key to what makes a capitalist economy work is also its greatest weakness -- leverage. Every time a financial institution initiates a transaction, it posts collateral to make good on a trade, explains Levente Mady, fixed-income strategist for MF Global, one of the largest financial intermediaries in the world.

When the housing bubble burst in the U.S., the alphabet soup of acronyms that represent derivatives of mortgage loans and other financial instruments were undermined and financial institutions no longer could be assured that the collateral offered to back a transaction was worth the value ascribed to it. In short, financial institutions didn't trust each other. And a financial institution unable to lend or borrow is toast.

To grease the gears of commerce, central banks do something mysterious; they inject liquidity into the system. It's a meaningless phrase to those outside the inner circle of economists, policy wonks, financial analysts, bankers, brokers and others who actually find this stuff interesting, but the latest move by the U.S. Federal Reserve illustrates how it is accomplished.

The Fed has given senior dealers -- the 20 banks and investment houses that deal directly with it -- an offer they can't refuse. In exchange for their illiquid debt, including mortgage-related securities, the Fed will lend them government-guaranteed securities, such as treasury bonds, which those financial institutions can then lend to other firms for cash. This follows similar earlier schemes, such as the Temporary Auction Facility that allowed banks to use mortgage-backed securities and other dubious structured investments as collateral at 85 per cent of their face value even though they are virtually worthless. The Fed began with a $30-billion program in December, raised it to $90 billion in January, bumped it up to $100 billion in February and doubled it to $200 billion on Tuesday.

This is in addition to the commitment by the European Central Bank, which has been engaged in this sort of activity for several months, to add about $45 billion to the several hundred billion previously pledged. For its part, the Bank of Canada has ponied up $4 billion in two tranches of $2 billion each but it imposes stiffer quality requirements than the American plans.

"If the Federal Reserve and other central banks weren't providing this liquidity there would be a number of very large players in big, big trouble," Mady says. Indeed, it was widely reported that the credit facility was timed to bail out Bear Stearns, a brokerage firm struggling with higher borrowing costs and mortgage-related losses that was deemed too large to be allowed to fail.
Mady blames the central banks for creating the now rapidly-deflating liquidity bubble in the first place, dating back to 2002 when interest rates were lowered to one per cent, or perhaps even earlier during the irrationally exuberant run-up in technology stocks.

The question that needs to be asked is whether some of the biggest global financial institutions are still solvent. If not, they will need to swap their dubious debt for securities backed by governments indefinitely. That's the bottom line of this costly program to shore up the balance sheets of financial institutions. Their bad bets will be covered by taxpayers.

It's difficult to fathom how these cosy arrangements between central bankers and their clients serve the public interest. Shouldn't financial institutions that make the wrong choices face more serious consequences than accounting writedowns?

Assuming the worst, that governments are paying the equivalent of hard dollars for paper worth pennies or less, the result could be a significant drain on governments' financial resources, forcing some into deficit (or increasing deficits of countries that already have them). That could mean higher taxes, reduced spending on social programs or both. The central bank swaps of good money for bad could also stoke inflation.

Meanwhile, U.S. consumers, who account for roughly 72 per cent of the American economy, are getting whacked. Many have descended into negative equity territory as house prices have dropped and credit lines were pulled. Barring some sort of intervention to relieve homeowners of their mortgage obligations, as many as two million foreclosures are expected this year alone.
Clearly, the liquidity injection is a Band-Aid that fails to address the problems underlying the global financial system's distress. The virus that has brought the world's strongest economy to its knees has to run its course.

Canada is not immune from the malaise. The manufacturing sector is already reeling and there's little reason for optimism with the Canadian dollar at or over par. Exports make up about 40 per cent of the Canadian economy and 80 per cent of our exports are destined for the U.S.

And, of course, the credit crisis has infected the stock market. Investors can try to second-guess the peaks and valleys of a volatile bear market but it's a mug's game for most of us.

The best defence, suggests MF Global's Mady, is to play defence. Looking back a couple of years from now, a government of Canada bond that secures principal and yields 2.75 per cent annually might seem like a good deal.
henchin@png.canwest.com
© The Vancouver Sun 2008